The Difference Between Angel Investors and Venture Capital
For business owners looking for early equity financing, three basic options exist: friends and family, angel investors, and venture capital funds.
Since you likely already understand the dynamics behind the friends and family financing option and using your own money to capitalize the business, read on to learn more about the main differences between angel investors and venture capitalists, two very different institutions with very similar goals.
Related: What is crowdfunding?
An Overview of Angel Investors
In Silicon Valley culture, investing in a high-speed startup that achieves “unicorn” status ($1 billion in enterprise value) confers a certain honored status on the investor, usually a high net-worth individual. These wealthy individuals have played a key role in providing early equity funding for some of the world’s largest businesses when they were early-stage companies.
As a business owner on the search for equity capital, consider enlisting the finances and expertise of an angel investor in your industry. These individuals have a high net worth and may also have played the part of entrepreneur earlier in their careers.
To become an angel investor, the individual must meet the qualifications as an accredited investor. This means having a minimum net worth of $1 million and an annual income of at least $200,000 to be considered an accredited investor.
Related: How to find angel investors
Angel Investor Funding Ranges
Generally, an angel investor(also referred to as a seed investor) will provide an initial round of equity financing in the range of $10,000 to $500,000. This funding round precedes the formal venture capital process. This range can also vary from market to market and investor to investor.
Some deep-pocketed angel investors known as “super angels” may invest even more than $750,000, though the vast majority of early investors will not exceed $1 million.
At any investment size, an angel investor will want to review your business plan and high-growth potential.
Angel Investor Motivations
The technology industry over the last 30 years spawned a culture of giving back. Angel investor motivations include prestige, a desire to help budding companies grow, and interest in potentially achieving giant returns on their initial small investment.
Types of Angel Investments
Most angel investors will agree to pay a sum of money in exchange for equity in a business. The exact percentage of equity depends on the agreement the business and angel come to, but usually revolves around 10% to 20%.
In essence, an angel investor becomes one of the first equity partners in the business aside from the founders. Usually, these investments remain passive rather than operational.
Famous Examples of Successful Angel Investors
Some of the most famous angel investors include Marc Andreessen of Twitter and Facebook fame, Roger Ehrenberg, Keith Rabois, and Mark Goines. Collectively, these angel investors have made hundreds of early investments into today’s well-known megacorporations.
An Overview of Venture Capital Firms
In contrast to angel investors, venture capital firms (or VC firms) raise outside funds from limited partners. The operators of such funds, also known as the general partners, then make strategic investments in potentially dozens of early-stage startup companies.
Venture capitalists have different motivations and investing requirements that set them apart from angel investors. In short, venture capital firms utilize organized corporate structures to make investments, whereas angel investors merely invest for themselves.
The Venture Capital Industry
The modern venture capital industry formed in the wake of the explosion of wealth in the Silicon Valley area. Venture capitalists form partnerships, often “limited liability partnerships” or LLPs, to raise funds and invest the proceeds in promising businesses.
Venture capitalists anticipate that most of their investments will fail but hope that at least one achieves unicorn status or otherwise produces a sizable return on their initial investment. Once the business has achieved a certain size and meets SEC regulatory requirements, then the venture capital firm can achieve a “liquidity event” when the firm undergoes an IPO (initial public offering) in which shares of common stock float on the market.
Types of Venture Capital
Venture capital investment funds will target different growth stages and different industries, including:
- Series A Rounds: At this stage, startups have just begun to grow and expand their operations. There exists a high failure rate at this stage.
- Subsequent Rounds (Series B and Up): As startups grow, they need additional capital infusions to continue operating prior to achieving profitability. Consequently, many venture capital funds will then make subsequent investments for an additional equity stake.
- Expansion Rounds: At some point, a growth-stage company may begin to turn a profit. Some venture capital firms will make either a debt or equity investment in the newly-profitable firm.
Venture capital firms come in all shapes and sizes. Some target companies opportunistically, while others operate secretively and rely on their personal connections to seek out companies that meet their criteria.
Venture Capital vs. Private Equity
For mature or late-stage growth companies, another type of investment firm that often comes into play, also known as private equity firms, may choose to invest. Private equity firms differ from venture capital partnerships in a number of important ways:
- Motivations: Private equity firms tend to purchase mature companies with operational issues. The private equity fund then recapitalizes the firm with a new mixture of debt and equity, replaces the management team, and then resells the company for a higher price than they originally paid.
- Investment Size: PE firms can operate at all sizes. The largest firms, also known as “megafunds,” include firms like Blackrock and KKR.
- Selection Criteria: Many PE firms will select companies with stable cash flows, the potential for operational improvements, and those which may not have unlocked their full value with their existing capital structures.
Ultimately, most small business owners will likely only encounter a private equity firm once the business has achieved a certain EBITDA (earnings before interest, taxes, depreciation, and amortization). For instance, one PE firm we surveyed for this article had a minimum EBITDA of $5 million before they would consider a buyout.
The Key Differences between Angel Investors and Venture Capitalists
The differences between angel investors and venture capitalists also revolve around the following points:
- Motivations: An angel investor will usually have the motivation of helping a young company to succeed while also profiting handsomely. A venture capital firm will spread its bets across many companies in the hopes that one succeeds.
- Amount of Financing: Angel investors usually provide the first “seed” round in which the business receives its first outside investment. Venture capital firms can invest many millions of dollars in a growth-stage business.
- Investment Vehicles: Angel investors usually receive a 10% to 20% equity stake in the company, while venture capital firms may use more complicated vehicles such as convertible debt, mezzanine financing, or ask for much larger amounts of equity for a given investment level.
- Relationship Type: An angel investor represents themself rather than a large investment partnership. The relationship between an angel investor and a small business will become much more intimate than that between a VC fund and a startup.
Picking the Right Type of Investor for Your Business
The right type of investor depends on which stage your business currently resides. If you have recently founded a business and want to acquire outside funding, an angel investor may constitute your best chance of success.
On the other hand, if you’re seeking a much larger amount of funding than an angel investor can provide and your business has achieved certain growth metrics, then a venture capital fund may act as the more appropriate option for your startup.
Lastly, consider that venture capitalist firms will conduct much more due diligence due to the higher stakes involved, whereas an angel investor doesn’t care as much about the high risk and formal valuations.